Forex Investment and Currency Trading

Turkey’s heavy external financing needs, in addition to the high level of foreign ownership of local debt and equities (30% of the debt market, 70% of equity), points to contagion from global risk aversion ahead and a weaker currency.

The Central Bank is in a difficult position. On the one hand, the economy is weak, domestically generated price pressures are limited as the output gap is negative, and real interest rates are high. On the other, inflation is set to overshoot the year end target due to external price shocks (food, oil), as well as regulated price hikes. Faced with a delicate balancing act, CBRT slowed the pace of interest rate cuts to 25bp in January and February and left official rates on hold in March. Expect a prolonged period of steady policy ahead, as the Bank cannot take any action that would undermine the currency from here.

y/y changes in USD/TRY and headline CPI are well correlated, while lira weakness tends to increase inflation expectations. In recognition of weak external conditions, the CBRT has already scaled back the size of daily FX auctions. High real interest rates are a deterrent to long USD/TRY positioning, but retail accounts locally have become less willing to convert USD and EUR desposits into local currency.

For now the government is maintaining tight fiscal policy, which will help the CBRT’s battle with inflation and help contain the current account deficit.

However, it has yet to decide how to proceed with the IMF when its programme expires in May. The market will want to see some Fund monitoring of government policy in order to reduce the risk of fiscal slippage ahead. Locals are concerned about more populist policy initiatives as the government starts to focus attention on local elections in the spring of 2009.

The political outlook has deteriorated with the General Prosecutors’ decision to apply to the Constitutional Court for a ban on the ruling AKP and many of its members, including PM Erdogan. This case could take a year to complete. Best case is that funding is ended for the AKP. However having seen two of the AKP’s predecessors closed, few will bet on such a ‘benign’ outcome. The AKP is popular and without Mr Erdogan at the helm politics could become highly fragmented again. The EU has also warned that the AKP’s closure may also bring a halt to Turkey’s EU accession talks.